Third Circuit Upholds Validity of SEC: Amendments Clarifying Exemptions from Section 16 Liability

The Third Circuit recently upheld the validity of two clarifying amendments adopted by the SEC in 2005. The amendments clarified two important exemptions from shortswing-profit liability under Section 16(b) of the Securities Exchange Act: (1) Rule 16b-3, which exempts certain transactions between an issuer and its officers or directors; and (2) Rule 16b-7, which exempts certain mergers, reclassifications, and consolidations. In so doing, the Court expressly overruled a prior decision of the Third Circuit that imposed novel restrictions on the applicability of the two exemptions.

In Levy v. Sterling Holding Co., 314 F.3d 106 (3d Cir. 2002) (“Levy I”), the Third Circuit held that grants, awards, and other issuances to officers or directors must be compensation-related to be eligible for exemption under Rule 16b-3(d). The Third Circuit also suggested that Rule 16b-7 would not exempt reclassifications that involve classes of securities with different risk-return characteristics (such as an exchange of non-convertible preferred stock for common stock) or that increase shareholders’ percentage of common-stock ownership. (See our memo dated March 10, 2003.)

In response to the Third Circuit’s holding in Levy I, the SEC adopted clarifying amendments to Rules 16b-3 and 16b-7. The amendment to Rule 16b-3 made clear that the exemption would apply regardless of whether a compensation-related purpose could be demonstrated. The amendment to Rule 16b-7 made clear that the only condition for exempting a reclassification is that the company whose securities are acquired or disposed of owns 85% or more of the equity or assets of all companies that are parties to the transaction. Thus, where a single issuer reclassifies one class of its securities into another, there is effectively 100% “crossownership” and the exemption is available. (See our memo dated August 8, 2005.)

In Levy v. Sterling Holding Co., No. 07-1849, — F.3d — (3d Cir. Oct. 1, 2008), the Third Circuit upheld the clarifying amendments as valid exercises of the SEC’s authority under Section 16(b) to exempt transactions “not comprehended within the purpose of” the statute. The Court held that the clarifying amendments “easily pass muster” under the relevant standard, known as Chevron deference, which provides in relevant part that an agency regulation promulgated pursuant to an express statutory grant of authority is subject to challenge only if it is “arbitrary, capricious, or manifestly contrary to the statute.”

In addition, the court rejected the argument that the clarifying amendment to Rule
16b-3 substantively changed the law and thus could not be applied to transactions pre-dating the amendment’s 2005 adoption. In so holding, the Court explained that “four factors are particularly important” for determining whether an amendment merely clarifies or substantively changes the law: “(1) whether the text of the old regulation was ambiguous; (2) whether the new regulation resolved, or at least attempted to resolve, that ambiguity; (3) whether the new regulation’s resolution of the ambiguity is consistent with the text of the old regulation; and (4) whether the new regulation’s resolution of the ambiguity is consistent with the agency’s prior treatment of the issue.” Since the Court’s holding that the clarifying amendment to Rule 16b-3 properly applied to pre-adoption transactions was sufficient to uphold the dismissal of the complaint before it, the Court did not decide whether the clarifying amendment to Rule 16b-7 could be applied to transactions pre-dating its adoption.

Finally, the Court held that, “notwithstanding the doctrine of stare decisis, Levy I does not foreclose us” from applying the clarifying amendments to this case, as “a judicial opinion construing an agency’s regulation does not necessarily bar a court from giving effect to a subsequent, different interpretation by the agency, unless, according to the earlier opinion, the judicial construction flowed unambiguously from the terms of the regulation.” The Court noted that its holding in Levy I was predicated on its best efforts to interpret ambiguities in Rules 16b-3 and 16b-7 that the SEC’s amendments have now clarified.